The credit crisis that imploded in July 2007 was not a Black Swan event that could not be predicted. It actually began in late 2006 when inevitable residential subprime defaults that had been warned by a few lonely voices on the Internet from a few sober analysts years earlier were finally being reported in the general print media and popular TV programs on finance. The general consensus continued to claim the economy to be fundamentally sound. Pundits at the Wall Street Journal, CNBC and Bloomberg told the clueless public to take advantage of buying opportunities as the market headed south.

By the end of the first quarter of 2007, speculative institutional buyers of investment properties at overblown prices began having problem accessing easy credit to close their overpriced deals. Nervous investors in high-yield fixed income debt began redirecting their funds towards risk-free Treasury notes and bills, driving prices up and interest rates down. Balance sheet loans (cash generated from operations) from banks and insurance companies were still available but at far more conservative credit terms and higher rates. Still, mainstream analysts were insisting the sky was not falling.

The pace of securitization, including commercial mortgage-backed securities (CMBS) issuances, slowed moderately during 2006 and 2007 from the fast pace set between 2002 and 2005, especially for high-leverage private sector issuers. The trend was hailed as a successful soft landing by mainstream pundits while in reality any slight loss of upward price momentum is lethal for a debt bubble.

The stock and bond markets reacted to the rising rate of delinquencies among subprime residential borrowers as the housing bubble deflated. Investors lost confidence in even the top-rated tranches of the securitized subprime loans and all asset-backed securities became illiquid. Hedge funds managed by Lehman, Bear Stearns, Merrill Lynch, Goldman Sachs and others that had purchased subprime asset-backed securities (ABS) reported huge losses as their portfolios were marked to market. Globally, off shore hedge funds and major banks in Germany and France that invested in subprime ABS also reported significant losses. Investors seeking to increase returns had leveraged their ABS holdings which, when applied to a market decline, exponentially drove prices even lower.

Large US investment banks had pooled subprime residential asset-back securities (ABS) totaling $383 billion and sold the paper to investors worldwide in 2006. By September 2007, 21% or about $80 billion of the mortgage securities were in default, plus another $20 billion sold by smaller firms. There were $18 trillion of all forms of outstanding ABS, and market analysts estimated at the time that marked-to-market losses would be in the range of $400 to $600 billion. Yet media reports cited only about $150 billion of acknowledged losses as of the end of 2007. The trough, of which no one had any reliable estimate, remained in the unknown future despite the Federal Reserve’s frantic rate reductions, which by December 2008 has reached near zero. The impact of the subprime defaults had been magnified as firms purchased for a fee slices of these original-rated pools and repackaged the assets a second time, rated them a second time, and later sold them as lower-tiered units at higher yields to investor with bigger risk appetite. The impact has been global as most international money center banks have offices in all major financial centers around the world. (Please see my November 27-29, 2007 AToL three-part series on Pathology of Debt)Going forward, the credit crisis will bring down the retail and office real estate sectors in all economies as a global re-pricing of risk alters the viability of maturing medium-term loans coming due in coming years. From early mid-2004 to mid-2007 real estate developers, lenders and property owners used a menu of complex financial instruments to gain access to low-cost funds and shift risk off their balance sheets to the investing public. Easy access to credit had driven capitalization rates way down and debt-financed deal volumes up to new record levels every year since 2002. Institutional-grade assets had been priced using exponents in future cash flow assumptions in an upward-bending positive parabolic curve. It is inescapable that when global credit markets turn sour, the effect is an equally downward-bending negative parabolic curve.To be fair, Bernanke was in good company among establishment experts of equally unjustified complacency. Brookings Policy Brief Series#164 dated October 2007, three months after the credit crisis imploded, used as headline: Credit Crisis: The Sky is not Falling. The brief by Anthony Downs, who describes himself on his website as the “World’s Leading Authority” on real estate and urban affairs, asserts that

“… the facts hardly indicate a credit crisis. As of mid-2007, data show that prices of existing homes are not collapsing. Despite large declines in new home production and existing home sales, home prices are only slightly falling overall but are still rising in many markets. Default rates are rising on subprime mortgages, but these mortgages—which offer loans to borrowers with poor credit at higher interest rates—form a relatively small part of all mortgage originations. About 87 percent of residential mortgages are not subprime loans, according to the Mortgage Bankers Association’s delinquency studies. Subprime delinquency rates will most likely rise more in 2008 as mortgages are reset to higher levels as interest-only periods end or adjustable rates are driven upward. Unless the U.S. economy dips dramatically, however, the vast majority of subprime mortgages will be paid. And, because there is no basic shortage of money, investors still have a tremendous amount of financial capital they must put to work somewhere.”

However, while this complacent view was widely held in the financial establishment, not everybody was drinking the Cool-Aid. Instead of “tremendous amount of financial capital”, the entire financial sector was seriously undercapitalized as distressed debts added up losses. Warnings had been publicly aired months before the credit crisis imploded in July 2007 by a few lonely voices of more sober analysts that the subprime mortgage bubble would burst and its effect would spread globally, granted that such warnings had been summarily dismissed by the establishment media. (See my March 17, 2007 AToL article:Why the Sub-prime Mortgage Bust Will Spread)

By December 2008, eighteen months after the credit crisis broke out in July 2007, events have conclusively proved that Bernanke’s faith in the magic of the Greenspan Put had been misplaced. Decades of misapplication of Friedmanesque monetarism had driven the doctrine into theoretical bankruptcy. Monetarist measures not only fails to revive an economy caught in a global debt tsunami, there is also clear evidence that the liquidity cure devised by Greenspan has eventually run out of ammunition as the serial bubbles get bigger each time to paper over the previous one. The Greenspan Put does not work for a stalled economy facing a liquidity trap of absolute preference for cash. It only adds more water to a raging flood of debt to threaten even the shrinking remaining high ground.

The flaw in his faith in self-regulating monetarism that Greenspan openly confessed before Congress apparently did not get through to Bernanke who continues to apply the Greenspan Put. Bernanke’s futile monetary moves to save wayward financial institutions only managed to increase the immunity of the deeply wounded economy against any Keynesian fiscal cure by the next occupant of the White House and his economic team. Bernanke made the same mistake of obstinate denial in the early phases of the economic meltdown from a debt crisis even after his acceptance eight years earlier of Friedman’s counterfactual conclusion that the Fed in 1930 failed to act in time to effectively respond to the oncoming disaster with bold monetary countermeasures. Again, the world missed another opportunity to test if preemptive Keynesian fiscal cures will work.

More fundamentally, rather than a timely monetary cure as proposed by Friedman in hindsight, Hoover should have applied Keynesian demand management through fiscal spending to maintain full employment immediately after the 1929 crash, if not before. No recovery from speculative excess can be expected without a policy-induce rise in employment and wage income to catch up with an asset price bubble. It was true in 1929; and it is true today.

Unfortunately, the rescue approach by the Bush administration led by Treasury Secretary Henry Paulson and the Bernanke Fed has been focused on saving distressed financial institutions by providing taxpayer money to restructuring bad debts and de-leveraging overblown balance sheets. This approach inevitably pushes already stagnant wage income further down with more layoffs and ruthless renegotiation of already draconian labor contracts to cut operating cost. All this does is to reinforce the downward market spiral by transferring financial pain to innocent workers while not helping the economy with needed revival of consumer demand.

Trillions of good taxpayer money are being thrown after bad debts concocted by unprincipled financiers into a crisis black hole. This money would have to be repaid in coming years by tax payers while Supply-siders are clamoring for tax cuts for corporations, on capital gain and for high income earners. This means the future tax bill to pay for the Greenspan put will be borne by low and middle income wage earners. Thus far in this financial crisis, the Bernanke Fed has not sowed the seeds for a quick recovery but for a decade or more of stagflation for the US and the global economy.

Wang Gungwu

If you don't have a sense of the past, your future will be diminished. Knowing where you come from, where your roots are, and all those great - and terrible - things that happened in the past, strengthens your identity